ESOP Operational Issues
Allocation Restrictions Triggered by a Section 1042 Sale to an ESOP (Part 3)
June 16, 2010Let us continue the discussion of the non-allocation restrictions of Code Section 409(n) by defining a more-than-25% shareholder for this purpose. A person will be considered a more-than-25% shareholder if he or she owns more than 25% (in terms of either number of shares or value) of:
Indirect ownership is considered as well as direct ownership. An individual is considered to indirectly own the shares that are owned by the following related individuals or entities:
- Any class of stock of the company issuing the shares sold to the ESOP, or
- Any class of stock of any corporation in a controlled group of corporations with the corporation issuing the shares sold to the ESOP.
An individual will be considered a more-than-25% shareholder if he or she owns, directly or indirectly, more than the 25% at any time during the one-year period ending on the date of a particular Section 1042 sale. If a person meets this criterion, he or she is prohibited from ever receiving an allocation of the Section 1042 shares acquired in that transaction.
- Children and grandchildren
- Partnerships and S corporations
- Estates and trusts, including the ESOP trust
A person may become a more-than-25% shareholder in the future as the shares acquired in a leveraged Section 1042 transaction are still being allocated among ESOP participants. This is important because any participant who is a more-than-25% shareholder on the date of any allocation of the Section 1042 shares cannot receive an allocation of those shares. Note that the shares in a participant's ESOP account are considered to be owned by such person for purposes of this test. Hence, it is possible that the ESOP allocations will cause a person to become a more-than-25% shareholder and become ineligible for further allocations of 1042 shares. Although this is not entirely clear, an ESOP participant should be able to receive an allocation of shares that causes him or her to exceed the 25% limit with future allocations ceasing at such point (unless and until the ownership drops below 25% at some point in the future).
There are a few miscellaneous questions I would like to address:
If a violation of Code Section 409(n) has occurred, you should consult with your ESOP advisors on possible correction alternatives.
- Since Code Section 1042 is available only with respect to a sale of C corporation stock to an ESOP, does Section 409(n) apply to an S corporation ESOP? Yes, to the extent that there was a Section 1042 sale to the ESOP before the company made the S election.
- What is an "allocation in lieu of"? The concept here is that not only is the affected person prohibited from receiving an allocation of the 1042 shares but he or she also is prohibited from receiving a "make-up allocation." In other words, it is not possible to make a cash contribution to the ESOP or another qualified plan on behalf of such individual in an amount that he or she would have received as a stock allocation absent these rules. Note however, some companies do attempt to make these individuals whole through allocations in a nonqualified arrangement.
- What are the consequences of violating Code Section 409(n)?
- One likely consequence is the failure to follow the terms of your ESOP document as most documents include provisions that incorporate the rules of Code Section 409(n). Failure to follow the terms of the plan document could lead to the disqualification of the ESOP.
- The individual receiving the prohibited allocation will be deemed to have a taxable distribution equal to the amount of the prohibited allocation.
- The employer sponsoring the ESOP must pay a 50% excise tax on the amount of the prohibited allocation.
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